INVESTMENT NOTE A Case for Collateralized Loan Obligations (CLOs) June 2013 A Case for Collateralized Loan Obligations 1 SHENKMAN CLOs are in the midst of staging a big comeback with over $30 billion year-to-date and over $50 billion in issuance last year, the highest in five years as the structures withstood the Great Recession and the resulting default cycle. As yields of other asset classes decline, a number of institutional investors are turning to CLOs because they offer investors the ability to access leveraged loans with the benefits of diversification, customized risk/reward profiles, attractive yields, leveraged returns and transparency with monthly reporting. Introduction Collateralized loan obligations are a type of securitization where assets, generally leveraged loans, are pooled together and the income and principal payments from that pool are paid out to investors in a specific order. A CLO raises money primarily by issuing its own bonds and then reinvests those proceeds into a portfolio of predominantly loans. Similar to a mutual fund, a CLO pools together funds from a variety of investors to give each investor greater diversity than otherwise would be achievable by investing directly in leveraged loans. However, all investors in a mutual fund are pari passu, and no one investor is more senior than another. In CLOs, and most securitizations, investors purchase specific tranches, or slices, of the transaction with a specific seniority structure and priority of payments. One of the key advantages of CLOs is that investors can gain exposure to leveraged loans while choosing a specific risk/return profile that suits their needs. The tranches of a CLO range from the most senior slice, which is always first in line to get paid but receives the lowest return, to the most junior tranche, known as equity, which receives all the residual income from the collateral pool of loans after the other tranches have received their income. Even with today s low-rate environment, equity tranches generally have expected rates of return in the low-to-mid teens. CLOs are similar in structure to other securitizations known as collateralized debt obligations (CDOs), which invest in ABS, mortgages, credit cards, student loans or other debt. However, CLOs have a very distinct return history and investor base. In this piece, we will focus on CLOs and their performance. Even within CLOs, there are several types as follows: 1. Static versus Managed CLOs: Static CLOs maintain the same pool of collateral throughout the life of the transaction. As the collateral is paid off the value of the pool declines. On the other hand, managed CLOs have dynamic collateral pools whereby the portfolio manager actively buys and sells assets. Therefore, the makeup of the pool will likely be very different over time. June 5, 2013 Alexander Chan Vice President, Quantitative Strategy and Analytics achan@shenkmancapital.com +1 (203) 363-1785 For more information, please contact: Nicholas G. Keyes, CFA, CAIA Director of Business Development marketing@shenkmancapital.com +1 (203) 348-3500 Highlights: The primary market for CLOs has opened up again, with over $50bn of issuance in 2012 and more than $30bn during the first five months of 2013. CLOs offer exposure to leveraged loans with customizable return and risk profiles. CLO tranches offer greater spreads than other similarly rated bonds. CLOs offer investors attractive spreads with calculated risks, which can be managed. 2. Balance Sheet versus Arbitrage CLOs: Balance Sheet CLOs are created for the purpose of securitizing certain assets and removing them from balance sheets to reduce regulatory capital requirements. Arbitrage CLOs are designed to take advantage of additional income from the pool of loans over the CLO s cost of financing (i.e., average coupon of the issued debt tranches).
A Case for Collateralized Loan Obligations 2 3. Cash Flow versus Market Value CLOs: Cash Flow CLO tests are based on the par value of the collateral. Market value CLOs use the market value of the collateral, which subjects the transaction to mark-to-market risk. 4. Cash versus Synthetic CLOs: Cash CLOs buy real assets (actual leveraged loans as underlying collateral). Synthetic CLOs are backed by credit default swaps on loans (LCDS), a form of swap agreement where one party can purchase insurance against a single entity s default in exchange for premium payments. Most CLOs historically were cash transactions, and no synthetic CLOs have been printed since the Credit Crisis. Nearly all outstanding CLOs and new deals coming to market currently are managed, cash flow, arbitrage deals. While there are many possible structures of a CLO, a typical one includes five tranches of rated debt and an equity tranche. The debt of a CLO is also referred to as the liabilities. Exhibit 1 below shows a typical structure for a recent vintage transaction. Exhibit 1: Typical CLO Structure Collateral Pool of Leveraged Loans 100-150 Issuers 20-25 Industries B+ to B- Averaged Credit Quality Actively Managed Principal Payments reinvested for 3-5 years Source: Shenkman Class A Rating: AAA (60-65% of deal) Class B Rating: AA (7-12% of deal) Class C Rating: A (5-7% of deal) Class D Rating: BBB (3-5% of deal) Class E Rating: BB (3-5% of deal) Class F Rating: B (0-3% of deal) Equity Unrated (8-12% of deal) The appendix has more details on the parties involved, lifecycle and key collateral tests of a CLO. History of the CLO Market As mentioned earlier, CLOs are a type of CDO that use leveraged loans in the collateral pool. CDOs were first issued in the late 1980s, and the first CLOs were issued about a decade later. The market remained relatively small for about a decade. In the early 2000s, institutional investors started seeking out higher yielding alternative investments because historically low interest rates at the time made interest rate risk a concern for many investors. Default rates were starting to decrease after spiking in 2002 to just over 8%. Therefore, exposure to leveraged loans became very appealing given the floating rate nature, seniority and security in the corporate capital structure. CLOs were a good option for domestic and foreign investors to gain exposure to the U.S. leveraged loan market without having the administrative burden of settling leveraged loans directly.
A Case for Collateralized Loan Obligations 3 Exhibit 2: Growth of the CLO Market Annual CLO Issuance Volume ($ billions) 100.0 97.0 88.9 90.0 80.0 70.0 60.0 52.6 53.8 50.0 40.0 33.3 30.0 20.0 10.0 25.5 13.314.6 9.1 12.1 16.2 12.3 13.50.8 4.1 0.0 1999 2001 2003 2005 2007 2009 2011 2013 2013 data points are YTD May 23rd. Source: S&P LCD Number of Unique Managers Issuing CLOs 120 110 100 98 80 63 69 69 60 55 40 42 39 31 35 28 20 17 3 10 0 1999 2001 2003 2005 2007 2009 2011 CLOs reached a peak in issuance in 2006 when $97 billion of deals were brought to market. The strong trend continued into 2007, with another $89 billion priced. By 2008, however, the weakness in sub-prime collateral led to a global Credit Crisis, which dramatically curtailed investor interest in all structured products, including CLOs. In turn, the Credit Crisis caused leveraged loan defaults to increase, and default rates for leveraged loans reached nearly 10% in 2009. By late 2010, the effects of the Credit Crisis started to wane and defaults rates began to decline. Investors remained cautious about re-entering the structured product market as many of their other types of CDOs suffered large losses. However, CLO investors quickly realized that using leveraged loans as collateral and the structure of a CLO differed in important ways than other CDOs. Fears of double-digit default rates and major Events of Default in the CLO structure were overblown, and in fact, the vast majority of actively managed, cash flow, arbitrage CLOs backed by a real pool of leveraged loans remained intact. At year-end 2012, S&P estimated over $280 billion in 670 transactions of CLOs were outstanding net of transactions that have been called 2. With over $30 billion of issuance year-to-date 3, there are now approximately $310 billion of CLOs under management. Moreover, CLOs represent the single largest type of investor in institutional leveraged loans today, accounting for over half of all primary institutional leveraged loans that come to market. 2 Standard & Poor's U.S. CLO Transaction Count And Assets Under Management By Collateral Manager As Of December 2012 by Robert J Radziul, published February 28, 2013. 3 Source: S&P/LCD. Year-to-date May 23, 2013.
A Case for Collateralized Loan Obligations 4 Exhibit 3: CLO Primary Market CLO Share of Primary Institutional Leveraged Loans Bank Loan Default (left) and Recovery (right) Rate 80% 70% 60% 50% 40% 30% 20% 10% 0% 1994 1997 2000 2003 2006 2009 2012 Last data point is 1Q13. Source: S&P LCD 2013 data point represents LTM March 31, 2013. As leveraged loan default rates remain benign, primary CLO volumes have dramatically picked up over the past year. The first quarter 2013 was the busiest first quarter on record with over $26 billion of issuance. In fact, the average monthly volume for the first five months of 2013 was $7 billion, despite a slowdown in primary issuance in April and May. Expectations are for liability spreads of CLO tranches to continue to decline in 2013 and defaults rates to remain benign. The asset class is once again attracting previous investors back to the market and many new investors are also showing significant interest. All of this activity is likely to lead to a healthy year of issuance for CLOs. Current vintage CLOs do differ from older vintage deals (pre Credit Crisis) in a few significant ways. Current CLOs have greater subordination as the AAA tranche now represents 60-65% of a new deal, whereas it used to be as much as 75%. Newer deals have on average been less levered (debt-to-equity). Lastly, newer deals comply with stricter ratings criteria and collateral tests. In other words, while CLOs survived the Credit Crisis relatively unscathed, they did go through a transformation. Many market participants refer to these newer vintage deals as CLO 2.0. Risk Factors 60% CLOs have a variety of risk factors, which can generally be summarized into three categories: structure risks, collateral risks, and overall macro risks. It is important to note that each tranche of the CLO capital structure has a different exposure to these risks. 1. Structure Risks: This category of risks is predominantly specific to CLOs and other structured products. They include risks related to how a deal is structured, including leverage, compliance tests, non-call periods, etc. The reliability and effectiveness of third parties involved in the transaction, such as the trustee, lawyers, accountants, and ratings agencies, is also a risk. 12% 10% The relative illiquidity of a CLO transaction would also fall under this category. The market for these transactions is not as deep as other credit markets, and many investors approach CLOs as buy-and-hold investments. Therefore, the liquidity of CLO tranches remains relatively limited. A nascent secondary market for CLO tranches is emerging, but many transactions are still largely done by appointment 8% 6% 4% 2% Default Rate Recovery Rate 0% 1995 1998 2001 2004 2007 2010 2013 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Primary CLO volumes have recently picked up significantly.
A Case for Collateralized Loan Obligations 5 and the number of market participants remains relatively small. Nonetheless, this is promising for the secondary liquidity of CLOs. The structural risks are likely the most prominent risks of a CLO, but they are also the most predictable. CLOs are governed by specific documents available to investors prior to purchase, and those documents lay specific guidelines on how a manager can invest the portfolio. Early investors can also negotiate terms to further reduce these risks. 2. Collateral Risks: This category of risk pertains to investing in sub-investment grade bank loans and is largely similar to the risks involved with a mutual fund or other vehicle that primarily invests in leveraged loans. These risks are driven by creditspecific events and can include default, recovery, downgrade, speed of prepayment, etc. Collateral risk also includes the risk related to investing with a specific manager. CLOs are ultimately large pools of investments with a portfolio manager. The manager s ability to avoid default losses and maintain a high level of income from the collateral pool is paramount to making the structure work. Collateral risks vary greatly between tranches. For example, defaults immediately affect the equity tranche, but barely affect AAAs. Like structural risks, collateral risks are largely expected, and in fact are modeled into the transaction itself. 3. Macro-Economic/Political Risks: As with nearly every type of investment, negative macro-economic and political events can impact both pricing and liquidity. This category would include broad risks like federal spending cuts, the economy, and monetary policy changes. The risks associated with this category are probably the smallest, but also the most unpredictable (e.g., country-level default, military conflict, or oil shock). Relative Value As mentioned earlier, the vast majority of CLOs are cash flow arbitrage transactions, which means investors are seeking to maximize the difference between the weighted average spread of the collateral pool minus the cost to finance that pool (weighted average spread of the liabilities). This dynamic drives the return/risk profiles for CLO investors. When loan spreads tighten, one would expect CLO spreads to also tighten, albeit at a much slower pace. Exhibit 4 shows the secondary spreads for older vintage CLO transactions. Prior to the Credit Crisis, CLO AAA spreads were as low as 20-25 basis points over Libor. While the Credit Crisis was initially centered around mortgage structured products, CLO tranches also traded down significantly based on those technicals. However, as the market recovered, levels tightened dramatically in the secondary market. Today, AAA levels have tightened to approximately L+110-120bps 4. 4 AAA coupon levels for primary deals from May 2013.
A Case for Collateralized Loan Obligations 6 Exhibit 4: CLO AAA Pricing CLO 1.0 secondary AAA spreads (bps) 900 800 700 600 500 400 300 200 100 0 1999 2001 2003 2005 2007 2009 2011 2013 Source: : J.P. Morgan, S&P LCD Recent Primary CLO AAA levels 160 150 140 130 120 110 100 Jan-12 Jun-12 Oct-12 Feb-13 CLOs can have a variety of structures, and underwriters are innovating with every transaction in response to different investor needs, manager styles, and ratings agency requirements. Nonetheless, a fairly typical structure for a CLO 2.0 is shown in Exhibit 5. Most AAAs are coming to market at par, hence coupon and discount margins match. Originalissue discounts are still in effect for lower-rated tranches. Exhibit 5: Typical Primary Market Structure (2013 Vintage) Class Tranche Percent Rating Coupon (bp) Discount Margin(bp) Class A Senior Priority 60-70% AAA 110-120 115-125 Class B Senior Subordinated 7-12% AA 155-175 155-200 Class C Senior Mezzanine 5-7% A 255-300 255-335 Class D Mezzanine 3-5% BBB 330-375 350-450 Class E Junior Mezzanine 3-5% BB 450-500 525-600 Class F Junior Mezzanine 0-3% B 550-650 650-750 Equity Preferred Notes 8-12% Unrated NA NA Source: Recent deal documentation, S&P LCD News, JP Morgan Global ABS/CDO - Weekly Market Snapshot, dated May 24, 2013. When compared to similarly rated leveraged loans or high yield bonds, CLO tranches offer far greater spreads. As mentioned earlier, CLO tranches are less liquid than loans of the same rating. Therefore, the additional spread is in large part to compensate investors for the illiquidity. The CLO structure would also account for some of the additional spread. However, for an investor that is comfortable with the reduced liquidity, the compensation can be profitable. For example, at year-end 2012, the average primary and secondary BB CLO tranche traded at 675-700bps 5, nearly 300 basis points more than BB leveraged loan spreads of 408bps 7. At year-end 2012, CLO BB tranches were nearly 300bps wider than BB leveraged loans. Even compared to asset classes that have similar risks related to the structured product transaction, CLOs still offer attractive levels. At the AAA level, structured products that have 5 Source: JP Morgan Global ABS/CDO - Weekly Market Snapshot : US HY CLO Spreads. Data as of December 27, 2012. 7 Source: S&P/LSTA Leveraged Loan Index. BB 3-year Discount Margin as of December 31, 2012.
A Case for Collateralized Loan Obligations 7 a similar average life as a AAA CLO tranche roughly three to five years trade at a fraction of AAA CLO spreads. Of course, the economic and collateral risks differ, but it still demonstrates a favorable relative value proposition for CLOs. Exhibit 6: AAA Spreads (3-5yr) (basis points) CLO Credit Card (Fixed) Credit Card (Floating) Prime Auto Student Loans CMBS 115 26 28 18 28-65 120 Source: JP Morgan Global ABS/CDO - Weekly Market Snapshot, dated May 24, 2013. Conclusion In many ways the Credit Crisis was an event that reinforced the main thesis for CLOs. While there was significant trading volatility during the crisis, the structure of the deals helped the integrity of the transactions. In the end, investors quickly realized that CLOs were one of the few structured products that fared well during the recession and the vast majority of transactions survived. Today, CLOs are quickly re-emerging as an alternative asset class for institutional investors to earn additional yield as more investors are looking for exposure to leveraged loans. CLOs offer investors attractive spreads with calculated risks, which can be managed. As a result, primary market volumes are increasing and more participants are entering the market. For more information, please contact: Nicholas G. Keyes, CFA, CAIA Director of Business Development nicholas.keyes@shenkmancapital.com marketing@shenkmancapital.com +1 (203) 348-3500
A Case for Collateralized Loan Obligations 8 APPENDIX A Parties Involved in a CLO In order to have a better understanding of CLOs, a brief discussion on the mechanics, lifecycle, and the parties involved in a CLO transaction is necessary. CLOs can vary greatly, but most will have many parties involved. Exhibit 7 shows a simplistic diagram of the various parties and how they interact. Starting at the top, an investment bank creates a Special Purpose Vehicle (SPV) that issues bonds that are rated by Moody s, S&P, Fitch or another major ratings agency, as well as an equity tranche. Investors purchase those bonds and equity. The money is used to fund purchases of leveraged loans for the collateral pool within the guidelines established by the rating agencies and transaction documents. The loans are chosen by the portfolio manager, who also manages the pool throughout the life of the transaction. Lastly, the trustee serves a key role for investors. The trustee monitors the transaction to ensure compliance with all the collateral tests established at the outset and provides investors with monthly reports. There are several other parties involved that are not listed. They generally include settlement agents, law firms, and accountants. Exhibit 7: Typical CLO Structure Portfolio Manager Investment Bank (Underwriter) SPV Investors Collateral Pool (Leveraged Loans) Ratings Agencies Trustee Source: Shenkman
A Case for Collateralized Loan Obligations 9 APPENDIX B Key Terms of a CLO 1. Warehouse: The process by which the portfolio manager begins to accumulate assets for a cash CLO. This generally begins once the manager and underwriter agree to work on a deal and can last from a few weeks to several months. Many deals today are done without a warehouse. 2. Ramp-up period: After pricing, the portfolio manager might have identified or acquired only 50-75% of the portfolio. The ramp-up period follows the closing and is the period of time needed to acquire the remainder of the initial portfolio. 3. Effective Date: The date by which the portfolio manager must acquire 100% of the portfolio and begin compliance with all CLO covenants and tests. 4. Diversity Score: A score, originally developed by Moody s, which measures the industry and issuer diversification of the portfolio. The score captures industry-related correlation by grouping obligors into 33 industries and assigning a numerical value to each industry that reflects the number and relative sizes of obligors within that industry. The higher the Diversity score, the more diverse the portfolio. 5. Weighted Average Rating Factor (WARF): A weighted measurement of the rating of every asset in the portfolio intended to provide a uniform method of comparing the ratings of different portfolios. The scale is ascending (see table below), therefore a high WARF Test is indicative of lower quality assets (lower ratings) and can result in a portfolio with a higher risk profile. Rating Factor Rating Factor Rating Factor Aaa 1 Baa1 260 B1 2220 Aa1 10 Baa2 360 B2 2720 Aa2 20 Baa3 610 B3 3490 Aa3 40 Ba1 940 Caa1 4770 A1 70 Ba2 1350 Caa2 6500 A2 120 Ba3 1766 Caa3 8070 A3 180 Ca and lower 10000 6. Over-Collateralization (O/C) Test: Over-Collateralization is the process of posting more collateral than is needed to obtain or secure financing. Thus, the test measures the ratio of underlying collateral versus the class (tranche) in question (and all classes above it). The Over-Collateralization, or par value, test requires that the collateral portfolio exceed the rated bonds by the minimum trigger level as set out in the Offering Memorandum. Example: Class C O/C = Total Par of Performing Collateral Par of Class A + Class B + Class C 7. Interest Coverage (I/C) Test: The interest coverage ratio is designed to ensure that the collateral pool generates sufficient interest cash flows to service the outstanding debt. Interest coverage ratios for each class are calculated similar to the O/C test, by dividing the total interest generated by the collateral by the amount of interest required to pay expenses and service each class of debt plus all classes above it.
A Case for Collateralized Loan Obligations 10 APPENDIX C Lifecycle a CLO The lifecycle of a current vintage deal can be thought of in approximately three main stages: 1. Marketing and Asset Accumulation (0-6 months): During this stage, the underwriter determines the underlying structural elements and assumptions of the transaction in conjunction with the portfolio manager. Negotiations are held with potential initial investors. The portfolio manager also begins to identify potential leveraged loans for the structure, and may begin to purchase them if there is a warehouse. The CLO is then priced (setting a final price for all tranches) and closed about a month later, during which time the manager purchases the majority of the collateral. For a primary CLO, the early months of a transaction generally adhere to the following timeline during this phase of the lifecycle: a. One month: Documentation of the deal, warehouse (if used), Offering Memorandum, and Investment Management Agreement. b. One to two months: Marketing of the debt tranches and other equity if needed. c. Pricing date: Once all commitments to fund the tranches are arranged, a pricing date is established to determine the spread (coupon) for all the liabilities. Typically, 50% of the collateral has been purchased on or around the pricing date. d. Closing date: Closing usually occurs 2-4 weeks after pricing. This is the date when the entire deal funds and the liabilities start to accrue. Typically, 75% of the collateral is purchased by this date. e. Effective date: The date by which 100% of the portfolio must be purchased. Ratings agencies also give final ratings. The effective date is generally not longer than four months after closing. 2. Non-Call Period: Equity investors have the final vote of when to call a CLO and close it completely. However, most CLOs have a non-call period so that all parties know the deal will be outstanding for at least a few years. Typically, the non-call period for recent vintage deals is two years. 3. Reinvestment Period: During the reinvestment period, the portfolio manager is charged with redeploying any principal repayment and any proceeds from sales into new leveraged loans. Most recent vintage deals have had four-year reinvestment periods. 4. Wind-down: After the reinvestment period ends, all principal proceeds go to pay down the CLO tranches starting with the AAAs (assuming the transaction was not called). Depending on the repayment rate, this can take three to four years (the average repayment rates for the past 15 years was 34%, according S&P/LSTA). However, as AAAs get paid down the average cost of financing the pool goes up, therefore, this wind-down period usually lasts about 18 months before the entire deal is called.
A Case for Collateralized Loan Obligations 11 Disclaimers and Notes The information and opinions expressed in this paper are for educational purposes only. The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services or an offer to sell or a solicitation to buy any securities. This paper, including the information contained herein, may not be copied, republished or posted in whole or in part, without the prior written consent of Shenkman Capital Management, Inc. 1. Shenkman is the marketing name for Shenkman Capital Management, Inc. and Shenkman Capital Management Ltd. Shenkman Capital Management, Inc. is registered as an investment adviser with the U.S. Securities and Exchange Commission. Shenkman Capital Management Ltd, a wholly-owned subsidiary of Shenkman Capital Management, Inc. is authorized and regulated by the U.K. Financial Conduct Authority. UK Residents: This material is provided to you because you have been classified as a professional client or eligible counterparty by Shenkman Capital Management Ltd as defined under the U.K. Financial Conduct Authority s rules. If you are unsure about your classification, or believe that you may be a retail client under these rules, please contact Shenkman Capital Management Ltd and disregard this information. 2. Third-party information contained in this presentation was obtained from sources that Shenkman Capital Management, Inc. considers to be reliable; however, no representation is made as to, and no responsibility, warranty or liability is accepted for, the accuracy or completeness of such information. 461 Fifth Avenue New York, NY 10017 +1 (212) 867-9090 262 Harbor Drive Stamford, CT 06902 +1 (203) 348-3500 49 St James's Street London, UK SW1A 1JT +44 (0) 20 3371 8234 www.shenkmancapital.com Copyright 2013 Shenkman Capital Management, Inc. All Rights Reserved